Start Up Law Lessons 4-6

Question 1

What is a term sheet?

Answer 1

is a preliminary document outlining the key terms of a potential investment agreement, specifying economic and governance rights before drafting legally binding contracts.

Question 2

What is the difference between preferred stock and common stock?

Answer 2

Common Stock:
-Owned by founders, employees, and sometimes early investors.
-Last in line to receive money in case of liquidation. (higher risk).
-Usually has voting rights but lacks special privileges.

Preferred Stock:
-Issued to venture capital investors in funding rounds (Series A, B, etc.).
-Has special rights like liquidation preferences, anti-dilution protection, and board representation.
-Can be converted into common stock (e.g., in an IPO or acquisition).

Preferred stock has more rights, like liquidation preferences and voting privileges, while common stock doesn’t.

Question 3

What is Series A preferred stock and Series B?

Answer 3

Series A Preferred Stock: The first institutional investment round.
Series B, C, etc.: Subsequent funding rounds, often with higher valuations and additional investor rights.

Question 4

What is a SAFE?

Answer 4

(Simple Agreement for Future Equity)
A debt-free (in early stages) investment mechanism where investors provide funding in exchange for future equity.

No maturity date, no interest, no repayment obligation (unlike convertible notes).

Protects early investors by offering valuation caps or discounts when they convert into preferred stock.

Question 5

What is a Bridge Note?

Answer 5

AKA: Convertible note

Short-term debt instrument that converts into equity in the next funding round.
Typically includes interest and a maturity date.
Investors receive a discount or valuation cap when converting to equity.
Used as “bridge financing” (Temporary funding) between rounds when a startup needs additional funding before a formal investment round.

Question 6

Differences between a SAFE and a Bridge Note?

Answer 6

SAFE =Simpler, no interest, no maturity date, no debt obligations.

Bridge Note = Loan with interest that converts into equity.

SAFEs provide future equity with no debt, while bridge notes are short-term loans that convert into equity.

Question 7

What does fully-diluted mean?

Answer 7

The total number of shares assuming all potential shareholders are counted, including options and SAFEs

Question 8

What is the charter?

Answer 8

Articles of association. The corporate contract that outlines the rules and structure of the company.

It defines:
-shareholder rights,
-voting mechanisms,
-board structure
-investor protections.

Question 9

What is a Liquidation preference?

Answer 9

Determines who and how gets paid first if the company is sold, liquidated, or merged.
t protects investors by ensuring they receive their investment back before common shareholders get paid. To mitigate risk.

Question 10

Types of liquidation preferences

Answer 10

1. Non-Participating Preferred Stock
2. Full Participating Preferred Stock (“Double Dip”)
3. Capped Participating Preferred

Question 11

What is a non-participating proffered stock?

Answer 11

Investors can choose between:

get back their original investment (and dividends, if applicable) after receiving their preference, they do not participate further in the remaining proceeds.

OR convert to common stock. (if that option gives them a higher return).

The investors get their investment SI o SI! El resto es para los common shareholders.

Question 12

What is Participating Preferred Stock (“Double Dip”)

Answer 12

Investors get their money back first, PLUS a pro-rata share of the remaining proceeds (alongside common stockholders).

Investors benefit in both good and bad scenarios. This heavily favors investors and limits founder upside. If the company performs poorly, founders and employees may end up with nothing.

Question 13

What is Capped Participating Preferred?

Answer 13

Investors get their money back first, but the total payout is capped at a certain multiple (e.g., 1M investment, 5M sell… if the cap is 2x, the investor receives a maximum of $2M, even if their pro-rata share would be higher.)

Ensures investors get a fair return but prevents them from taking too much upside.

Question 14

What is a Deemed Liquidation Event?

Answer 14

Mergers, consolidations, or asset sales where the control of the company changes

Question 15

The 3 alternatives of dividends

Answer 15

Non-cumulative: Investors only receive dividends if declared by the company.

Cumulative: If dividends are skipped one year, they roll over to the next year (e.g., 10% dividend accumulates yearly).

Participating (Preferred): Investors receive their preferred dividends first and plus share in common dividends.

Question 16

What are protective provisions?

Answer 16

veto rights on critical decisions, such as:
- Selling the company.
- Raising new financing rounds.
- Changing the corporate structure
- Issuing new shares

Question 17

What is a round down?

Answer 17

occurs when a company raises new funding at a lower valuation than before. This dilutes existing investors and founders.

Question 18

Anti-dilution protection

Answer 18

Protects investors from losing value in a down round by adjusting their conversion price.

Question 19

Types of anti dilution protection

Answer 19

• Full-Ratchet: Adjusts an investor’s price to match the lowest new share price. (the VC’s shares convert as if they paid the new price per share.)
• Broad-Based Weighted Average: Adjusts the conversion price based on how many new shares are issued.
  Less dilution than Full Ratchet, making it more founder-friendly.

Question 20

What are pro-rata rights?

Answer 20

Allows investors to maintain their ownership percentage in future funding rounds by purchasing additional shares.
Protects early investors from dilution when the company raises more capital.

Question 21

What are redemption rights?

Answer 21

Investors may have the right to force the company to repurchase their shares after a set period (e.g 5 years)

O sea: let investors sell shares back to the company after a certain period.

provides downside protection for investors in case the startup doesn’t exit successfully.

Question 22

How we assess the value of a company?

Answer 22

When investing in an early-stage startup, valuation is based on two main factors:

-The Idea: Is it innovative or disruptive? Does it have a competitive advantage?
-The Team: Are the founders and key employees capable of executing the business plan?

Question 23

What is mandatory conversion?

Answer 23

If the startup is successful, investors’ preferred stock automatically converts into common stock at the time of an IPO or major exit.
Often, founders negotiate multiple voting shares to retain control after conversion.

Question 24

What are preferred directors?

Answer 24

The Investor Director (or Preferred Director) represents investors on the board. Because VCs often require board seats to influence key decisions
This director must act in the company’s best interest but helps monitor the founders.

Question 25

What is a Start Up?

Answer 25

No legal definition of a startup yet. Generally, startups are high-growth, innovation-driven private companies in their early stages. Unlike mature corporations, startups lack stable revenue, assets, or a long track record. are typically high-growth ventures, often with the goal of being acquired or going public. They are backed by external investors, such as venture capitalists, and use equity to attract employees. Unlike traditional closely held companies, startups expect to evolve, either by scaling rapidly or by seeking an exit through (IPO).

Question 26

What's a Unicorn?

Answer 26

A startup with a $1 billion valuation or more.

Question 27

What is right of first refusal? ROFR

Answer 27

Investors get the first chance to buy shares if founders or employees want to sell.

Question 28

Drag along rights?

Answer 28

If a majority of investors approve a sale, all shareholders must agree, preventing minority shareholders from blocking deals.

Question 29

What are liquidation preferences, anti' dilution clauses, and voting rights for?

Answer 29

To protect investors while ensuring founders to retain operational control where possible.

Question 30

What are the 2 ways for a company to go public?

Answer 30

IPO: initial public offering = Issuing the first time new shares to the public. SPAC: Special Purpose Acquisition Company = A company that collects money from investors with the purpose of finding a private company with potential and make it public through a marge.

Question 31

What does it mean if a company is "closely held" ? Is a closely held company the same as a start up?

Answer 31

is a corporation which is owned by an individual or small group of shareholders , who are often members of the same family. Shares of a closely held corporation are generally not public, because they don't want to loose control of the company. No, start ups are typically high-growth ventures, often with the goal of being acquired or going public. They are backed by external investors, such as venture capitalists, and use equity to attract employees. Unlike traditional closely held companies, startups expect to evolve, either by scaling rapidly or by seeking an exit through an (IPO).

Question 32

How angel investors usually invest in startups?

Answer 32

through common stock or convertible debt.

Question 33

How VC's usually invest in startups?

Answer 33

by purchasing preferred stock with rights.

Question 34

What are stock options plans?

Answer 34

grant stock options as part of employee compensation, offering the potential for future equity in the company. This incentivizes employees and aligns their interests with the company’s long-term success.

Question 35

What is Free float?

Answer 35

the shares of a company that can be publicly traded and are not restricted (i.e., held by insiders). the number of shares that is available to the public for trading in the secondary market.

Question 36

What type of governance issues can arise in a start up?

Answer 36

A. Vertical conflicts (Vertical issues occur between parties at different levels of the governance hierarchy, typically between shareholders, the board, and management.) B. Horizontal conflicts (conflicts between parties at the same level of the governance structure, typically between different classes of shareholders or groups of stakeholders.)

Question 37

Describe the type of vertical issues

Answer 37

1. Shareholders vs. board: Conflicts can arise when VCs want to prioritize fast growth or an early exit, while founders may prefer more control or a longer-term strategy. VCs typically secure board seats and certain voting rights 2. Board vs. Founders: Founders may resist losing control leading to tensions with the board, especially when VCs have board seats and prefer experienced executives for the management. Issues arise when there is a misalignment between the board’s strategic direction and the founders’ vision. (Tesla example) 3. Shareholders vs. Founders: VCs may prioritize maximizing financial returns, and founders might prioritize retaining control, innovation, or company culture.

Question 38

Describe Horizontal Issues

Answer 38

1. Preferred vs. Common Preferred (VCs) have liquidation preferences (they get paid first) and Common (Founders) may want more founding rounds to better terms or more growth while VC want to exit fast. note: “[T]he law suggests that when push comes to shove, the board has a duty to prefer the common’s interests, as pure equity holders, over any desire of the preferred for better treatment based on some generalized expectancy that they will receive special treatment beyond their contractual rights.” - Chief Justice of the Delaware Supreme Court 2. Preferred vs. Preferred (Early vs. late stage investors) Later investors may negotiate for more favorable terms, creating conflicts between different series of preferred shareholders. Early investors may feel disadvantaged by the preferential terms given to new investors, leading to governance tensions. Also later pay higher prices per share, so different exit prices may be a conflict. 3. Common vs. Common (Employees vs. founders) Founders may retain a significant portion of equity and control, while employees receive stock options with varying vesting schedules. Over time, employees may feel misaligned with founders, especially if their stock options are diluted in future funding rounds or if they face different financial risks during an exit event.

Question 39

Why is it important to negotiate board seats?

Answer 39

Board composition affects decision-making power. Board has to function as a team.

Question 40

Why investors (VCs) want to monitor the board or the entrepreneur?

Answer 40

They want to control that the money is not in conflict of interests to protect their investment. They don't want the founder to use the money in perks, and extraction of private benefits (Buying wife's house example)

Question 41

Why the number of companies going public has decreased?

Answer 41

High compliance costs, securities law changes, technology and public market dynamics. Also the exit options like SPACS, private equity and wealth funds.